Letter - April 2015

 

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In Like a Lion and Out Like a ... Lion

After selling off in January, the market rallied in February only to fall once again in March. Little progress has been made and little damage has been done in the first quarter of 2015. Volatility has been high for stocks. Over one stretch in March the Dow Jones Industrial Average swung back and forth triple digits for eight days in a row. As we discussed in our January letter, such volatility and resultant anxiety is to be expected in the face of disruptions facing the world: ISIS, the collapse in the price of oil, the Russian invasion of Ukraine, Iranian nuclear negotiations, the Greek tragedy and dollar strength.

In a couple of weeks, companies will begin to report earnings for the first quarter. It is not expected to be pretty. Some expect earnings for the S&P 500 to fall, another headwind for stocks. Oil company earnings are sure to be down. Despite the windfall of lower gas prices at the pump, consumers showed little desire to spend their savings rather choosing to save or pay down debt. Perhaps this was due to harsh winter weather. A strong dollar will tarnish corporate earnings for those companies that do business overseas. So, it is possible that GDP will decline in the March quarter, tempering growth for the year overall. GDP growth seems likely to be stuck at an anemic 2.5% even after 6 years of zero interest rates.

Like Hamlet, the Fed equivocates as to whether to raise interest rates or not. We would love to hear Fed Chair Yellen’s soliloquy. While February employment numbers on the surface were strong, recent economic reports show deteriorating trends suggesting to some that the Fed will delay raising rates until September or even next year. A critical consideration for the Fed’s interest rate policy is the rate of inflation. For now, it remains far below the Fed’s target of 2%. This is puzzling given the massive printing of dollars (quantitative easing) by the Fed’s over the last number of years and suggests continued low interest rates for now.

Over the last six years, rising corporate earnings and artificially low interest rates have powered the market higher despite it being a period of intense anxiety and unexpected events. As we look into the future, there is cause to be cautious.

• Stocks are no longer cheap. The P/E ratio of the S&P 500 is in historically high territory.

• There have been numerous takeover deals. Contrary to logic, takeovers are typically done when stock prices and valuations are high, that is at market tops not at market lows. When markets are high, animal spirits run amok.

• Sooner or later, most likely in the next 3-9 months, interest rates will rise. It is unclear whether the market has discounted this and will shrug it off. The artificial suppression of interest rates for years has certainly contributed to the strong stock market. The return to normalized, market-determined interest rates may have the opposite effect. We worry. This is uncharted territory. Perhaps we are too cautious. A prolonged and drawn out series of interest rate hikes that Chair Yellen seems to suggest may not upset the apple cart. Keep your fingers crossed.

• While stock prices in general do not seem to be in a bubble, there are sectors within the investment markets that raise cause for alarm. Investments in the bio-technology sector have gotten frothy with out-of-sight valuations based on the promise of miracle drugs that have not yet been fully vetted. Venture capital investors are paying billions for social media start-ups with comparatively small revenue streams and where in some cases there is little idea of what is the actual pathway to profitability. The herd of "unicorns" (private venture portfolio companies valued at over $1 billion) is multiplying. As the March 28th Wall Street Journal notes:


“At least 78 privately held, venture-capital-backed companies are now worth at least $1 billion each, with a total valuation of more than $310 billion. Just 49 companies were worth $1 billion a year ago.”


Our strategy remains unchanged for the time being. We have been and will continue to selectively take profits. However, we have repeatedly said that it does not generally make sense to sell a stock high and reinvest the money in another stock that is high. We will sit on a substantial amount of cash until we find something unusually attractive or until the market has a meaningful correction.


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As a Registered Investment Advisor regulated by the Securities and Exchange Commission, P.R. Herzig & Co. is required to offer our clients copies of our form ADV Part 2. This form describes in plain English our business and how we operate. The form can be found on our website, www.prherzig.com. Hard copies are available upon request. There have been no material changes in the past year.


 

Tom Herzig


 

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